SEC Punts on Payments to ETF Market Makers

The Securities and Exchange Commission has decided not
to decide yet whether to approve proposals by Nasdaq and the
New York Stock Exchange to pay market makers to make better
markets in thinly traded ETFs. The proposals would require an
exemption from a current prohibition against such payments.

Rather than approving or rejecting the idea, the SEC decided
last Wednesday, July 11, to seek another round of comments on
pilot projects put forth by Nasdaq and NYSE Arca (the
electronic exchange formerly known as Archipelago). In its
83-page order instituting proceedings to determine whether
to approve or disapprove the proposed pilots
 posted on the
SECs web site last Thursday  the SEC
listed 27 questions asking for more input on specific points.
Theyre keying up the issues, said a source
who asked not to be named.

Under the law, the SEC has 45 days to respond to these kinds
of regulatory filings by the exchanges, with an automatic right
to extend the initial deadline by another 45 days.

July 11 was the 90-day mark for the Nasdaqs proposal,
and while the SEC had until August 14 to respond to NYSE Arca,
it decided to consider both proposals with a joint
order  a suggestion made by Vanguard, the
mutual fund and ETF sponsor headquartered in Valley Forge,
Pennsylvania, which filed separate comment letters on both
proposals.

Because both proposals raise similar regulatory issues
about the appropriate scope for permitting issuer payments to
market makers, we believe the Commission should consider the
two proposals together and not in isolation, said
Vanguard managing director and chief investment officer, Gus
Sauter, in a comment letter. But the two exchanges have
structured their proposed pilots very differently, and the SEC
said that it would also assess each separately.

The SECs order was published in the Federal Register
yesterday, July 17, and that starts the clock ticking on the
new comment period of 30 days. While that can be extended a
bit, the statutory deadline for final, definitive action by the
SEC now falls somewhere between early October and early
December.

The reason this is controversial is that in 1997, during the
dot-com era, the National Association of Securities Dealers
(NASD), which morphed into the Financial Industry Regulatory
Authority (Finra), adopted what is now known as Finra Rule
5250, prohibiting issuers from making payments to market
makers. Vanguard, in one of its comment letters, cited the
SECs statement when it approved the rule, on the
rules intent to prevent fraudulent and manipulative
acts, to promote just and equitable principles of trade and to
protect investors and the public.

At the time, the SEC observed that such payments would
prevent investors from determining whether price quotes were
based on actual investor interest or were inflated by a
securitys issuer or promoter.

Vanguard, in a separate statement delivered via email,
emphasized that in its comment letters, it had neither
supported nor opposed the proposed pilots, but rather had
asked for more time to consider them. The firm also said it was
contemplating further comments with the SEC, and
that it was concerned that the costs [associated with
payments to market makers] will likely outweigh the benefits to
long-term, buy-and-hold investors.

In 1997, the concern was the potential for manipulation in
small- and micro-cap stocks during the dot-com bubble. Back
then, the ETF industry was still very new and very
small.

Clearly, its a different world now, but its also
a different market environment because with the full
implementation of the National Market System, everything
became electronic, and that whittled away at
the economic incentives specialists in equities and lead market
makers in ETFs once enjoyed as an offset to the risks they took
in financing inventory and in maintaining tight bid/ask
spreads, notes John Hyland, the chief investment officer at the
United States Commodity Funds of Alameda, California and the
chairman of the newly launched National ETF Association. By
now, lead market makers really are not getting much of a
benefit, he says, adding its a puzzle as to
how you solve the problem without going backwards five, ten
years.

The main argument in favor of the
exemption  expressed by a number of
commentators  is that ETFs are made up of a basket of
stocks where its highly unlikely and probably impossible
that anyone could manipulate all of the components. Also, the
ETF sponsors wouldnt be paying the market makers
directly, but instead would voluntarily pay increased listing
fees to the exchanges, which would in turn pay the market
makers what the SEC describes as incentives to improve
the liquidity of the less actively traded or newer ETFs
that need support.

But during the initial comment period, one of the more
interesting questions raised was whether the programs would, in
fact, be voluntary.

In Question No. 11, the SEC noted that one commentator (and
yes, its Vanguard) questioned whether ETF sponsors would
end up being forced into a pay to play environment,
where they would have to cough up the additional payment to get
a new ETF launched, or even to maintain quality
markets in their existing ETFs. In asking for further
comments on this point, the SEC asked: Will market makers
gravitate to the ETPs [exchange-traded products] that
participate and avoid those that do not participate,
potentially rendering nonparticipating ETPs as funds with
diminished market making activity? Under this scenario, even if
the programs have the desired effect of enhancing market
quality for participating ETPs, might they have the unintended
effect of diminishing market quality (widening spreads and
limiting book depth) in nonparticipating ETPs?

In its comment letter on the Nasdaq proposal, Vanguard noted
that Nasdaqs proposed eligibility criteria would permit
any ETF with average daily trading volume of up to two million
shares to participate. In suggesting that the SEC might want to
consider whether a lower trading volume threshold would be more
consistent with the goals of the pilot and with the public
interest, Vanguard noted that of the 1,226 ETFs that existed as
of March 31, 2012 (not all of which are listed on Nasdaq), well
over 90 percent would meet Nasdaqs proposed eligibility
requirements.

Question No. 12 is interesting, too. There, the SEC wondered
whether either program could result in a prisoners
dilemma equilibrium, in which all eligible ETPs participate in
the program and achieve limited benefits while paying higher
fees. To address that possibility, the SEC asked for
comment on whether limiting the number of participating ETPs
per fund sponsor, as proposed under the NYSE Arca proposal,
would prevent market makers from pressuring issuers to place
every listed ETP into the program.

Nasdaq filed its own comment letter with the SEC on July 6,
in response to the comments made on its proposed pilot, the
Market Quality Program. On the pay-to-play
question, Nasdaq said it had taken great strides to make
the Market Quality Program wholly voluntary, and did
not envision that the modest market maker credit proposed
in the MQP . . . will transform the culture of the current ETF
landscape into a pay-to-play situation.

BlackRock also filed a comment letter about both
exchanges pilots on July 11  too late to
be noted by the SEC during this first round. Earlier this year,
BlackRock listed eight of its ETFs on the BATS exchange, which
has a liquidity program of its own that was approved by the SEC
last February. Under that program, market makers compete for a
daily reward by posting competitive quotes in either a stock or
an ETF, with the payment coming from BATS out of its regular
listing fees and not from any individual issuer or sponsor.

BlackRock said it believes the exchanges should be
allowed and encouraged to experiment and innovate unique
programs . . . in order to develop best practices over
time.

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